Millions of dollars in cigarette-tax revenue for the city are going up in smoke.

The Sheriff’s unit of the city Finance Department that conducted a sweep of 1,700 stores licensed to sell tobacco products found an astounding 42 percent either peddling untaxed cigarettes or using counterfeit stamps to duck the combined $5.85 city-state tax, The Post has learned.

“That is an alarming number,” said Jim Calvin, president of the New York Association of Convenience Stores, which represents 1,600 outlets around the state.

He said that while there’s no excuse for tax evasion, “it’s a reflection of the desperation of some store owners” trying to make ends meet in a jurisdiction with the highest cigarette tax in the nation.

The number of smokers in the city is falling each year — with Mayor Bloomberg crediting his administration’s anti-smoking policies for the drop.

But tax revenues from cigarettes are plummeting even more quickly.

The city took in $158.5 million from its share of the cigarette tax in 2003. Last year, collections were down to $69.8 million, a 56 percent drop.

During that same period, the smoking rate fell 28 percent.

Finance Commissioner David Frankel said his agency’s pursuit of cigarette tax cheats is as much about fairness as revenues.

“At a recent outreach event in The Bronx, I had a guy who came up to me desperate for help because his family’s delicatessen is going out of business because their competitors are selling illegal cigarettes and they refuse to do it,” Frankel recalled.

“It’s our job to protect them, and we’re going to do that.”

Most of the store owners caught in the sweep had only a few cartons of illegal smokes in their shops.

But in one case, a butt-legger led Finance Department agents to a storage locker. They installed a camera outside the facility, and it produced enough evidence for a search warrant.

Once inside, the agents seized 1,700 cartons of untaxed cigarettes and thousands of phony tax stamps.

In some cases, Frankel said the counterfeiting extends to the cigarettes themselves.

“They’re mostly cigarettes made in foreign countries,” he explained. “They’re brought in here and they’re mislabeled and they’re sold that way.”

A legitimate pack of Newports was selling yesterday for $10.75 at the Optimo shop on Park Row across from City Hall.

An illegal pack can go for as little as $5, according to grocery industry officials.

Frankel said the city is drawing up legislation to increase the penalties on those who flout the tax law because their impact “is devastating to small businesses” that are honest.

In an appearance before the City Council on Wednesday, Frankel said the penalties for those caught with a few cartons of untaxed cigarettes now is minimal.

Councilman Lew Fidler (D-Brooklyn) urged him to be more aggressive.

“Clearly, the people getting the four cartons are getting them from the people who have 40 cartons, who have the 4,000 [cartons] in the warehouse,” said Fidler.

The city is known for having the toughest anti-smoking laws in the nation, with bans on puffing in restaurants and even parks.

The Bloomberg administration also has sued residents for buying untaxed cigs on the Internet and has cracked down on “roll your own” tobacco shops.